Meticulous Consumption

James Park started a consumer products company largely because work at his previous startups was so sedentary he felt out of shape.

“I was looking for a way to lose weight,” says the three-time startup founder, who sold his last company, photo-sharing service Windup Labs, to CNet Networks four years ago. Applying entrepreneur logic, Park decided the solution was to launch a new startup, Fitbit, which makes a $99 clip-on device for tracking physical activity.

The San Francisco company raised $2 million last fall following a fund-raising effort that also qualified as a rigorous workout. “Initially a lot of investors have a knee-jerk reaction to hardware startups,” notes Park, who says potential backers worried about the expense and risk of prototype development, managing inventory and retail distribution. With a pitch focused on how small-volume contract manufacturing and on-demand retail models could reduce those risks, Park eventually closed the round in October, with backing from True Ventures and SoftTech VC.

Fitbit is one of 196 consumer products and services startups that raised a combined $1.6 billion from U.S.-based venture firms last year, according to Thomson Reuters (publisher of VCJ). That’s a substantial increase from the prior year, when U.S. VCs invested about $1 billion in the same number of startups. And while the overall amount represents just 2.6% of the total amount invested by U.S. VCs last year, it is telling that investment in consumer products and services is just behind semiconductors, which attracted $1.79 billion, or 2.9%, of the total.

Even with a weak domestic economy, entrepreneurs and venture investors say consumer-focused business models can be profitable as long as they address key behavioral and demographic trends, such as an aging population, rising environmental awareness and thriftier spending habits. Eventually, when the exit climate thaws, these startups will be poised to deliver serious ROI, investors say.

A consumer play doesn’t have to be a money pit, says Anthony Tjan, CEO and managing director of Boston-based Cue Ball Group, a venture fund that invests in retail and media businesses. That may come as a surprise to venture historians, who no doubt recall bubble-era grocery delivery service Webvan burning through more than $800 million before declaring bankruptcy. Or how even a VC success story, Amazon.com, took nine years to post its first profit.

But today’s consumer products and retail startups have come of age in a stingier era. Venture investors now look for portfolio companies to take a product from concept to launch on a few hundred thousand to a couple million dollars. And the bar for funding follow-on rounds has risen.

“One of the misunderstood components of consumer specialty retailing is that it actually requires fairly modest capital to reach proof of concept,” Tjan says. “They don’t have the same cost as, say, building a drug company. Very quickly, after a couple of units, you will know if it’s working. And in the small startup phase you have significant opportunity to kill these things early.”

Still, Fitbit’s Park cautions that, “Even though the cost of starting a consumer electronics company has gone down over the last five years, there are still a lot of upfront costs, like tooling to create plastic housing for products or building prototypes.”

Greener, Healthier, Cheaper

Not that Tjan has immediate plans to axe portfolio investments, most of which were made fairly recently. In the last year-and-a-half, Cue Ball has funded three consumer services companies: MiniLuxe, an ultra-hygienic nail salon, Epic Burger, a gourmet hamburger chain, and PlanetTran, an airport shuttle service that uses hybrid cars. Each is currently in expansion mode.

One of the misunderstood components of consumer specialty retailing is that it actually requires fairly modest capital to reach proof of concept.”

Anthony Tjan

Eclectic as those companies seem, their business models share common themes. For one, each has what Tjan calls a “Starbucks-like capability.” That is, they’re in sectors traditionally dominated by mom-and-pop businesses that have not built a multi-location retail platform that offers a consistent quality of service. The companies also fit into a broader consumer trend, meaning they offer people a way to feel greener, thinner, fitter or thriftier.

Poring over market research, entrepreneurs look for sectors that are large but still obscure enough to offer an untapped opportunity for scale. In the case of MiniLuxe, which Cue Ball incubated, Tjan determined that Americans spend huge sums on manicures and pedicures (nail salons were a $6.3 billion market in 2008, according to survey data compiled by Nails Magazine), but that there is no predominant brand for the industry.

Moreover, Tjan found that both cleanliness and pricing varied widely among nail salons, making it a dicey proposition to patronize an unknown establishment. MiniLuxe’s plan is to establish a brand as a clean, convenient place to get nails done for around $20. The chain, which currently has two locations in the Boston area, closed a $6 million Series B round last year to fund its expansion.

Reid Hutchins, vice president at Advantage Capital, applied a similar crunch-the-market-data approach before investing in a $500,000 round for Valhalla, N.Y.-based SOMS Technologies, a maker of highly efficient oil filters. “What we liked about it was it’s a cleantech deal.” Hutchins says. “It doesn’t involve massive infrastructure, like building a wind farm, but the technology does allow you to use less oil.”

Currently, the U.S. automotive oil change and lubrication industry includes about 4,000 companies with combined annual revenue of $4 billion, according to a report published last spring by First Research—and that doesn’t even include large fleets that do oil changes in-house. Not only are oil changes costly, notes Hutchins, they’re also a time-consuming chore that most drivers would prefer to be able to skip.

By using SOMS’ “microGreen” filter, he says “this will make it on the order of 20,000 miles that you have to do an oil change.” (It is commonly recommended that cars with standard oil filters have their oil changed every 3,000 miles.) In addition, the microGreen filters, which cost about $50 for a two-pack for a typical car, offer the environmental feel-good benefit of consuming less fossil fuel.

Even specialty bathtubs can potentially deliver venture-type multiples. Les Alexander, an Advantage partner in the firm’s New Orleans office, persuaded himself of that when doing diligence late last year on Safety Tubs, a manufacturer of acrylic walk-in bathtubs marketed to elderly and disabled customers. The Grand Prairie, Texas-based company considered bank financing, but determined its model fit better as a venture investment.

Safety Tubs is a relatively early stage company. And because it rents rather than owns its manufacturing facility, “it’s not heavy on physical assets you can lend against,” Alexander notes. He also liked that the company has relationships in place with home stores Lowes and Home Depot and that it is a “growth company that is in a great demographic position with the aging population.” That was enough to convince him to back a $2.5 million round for the company in December.

Now Playing

Judging by fund-raising data, at least a few firms are taking a stronger interest in the consumer products sector.

Among the newcomers is Chicago-based 2X Consumer Products Growth Partners, which raised $20 million earlier this year for a growth capital fund focused on food and beverages, personal care products, pet care and other branded consumer lines. Its team includes Andrew Whitman, a former Kraft executive in charge of Tang drinks, and Mike Levinthal, a former Mayfield Fund general partner and investor in Pete’s Wicked Ale. 2X has announced one deal to date: It invested an undisclosed amount in compostable diaper company gDiapers.

Any fruit juice with a kelp additive would be a fantastic way to go. Can you imagine, say a mango kelp juice mix?”

Stephen Pheiffer

Physic Ventures, a San Francisco firm, raised a $190 million fund last summer to invest in consumer-directed health and sustainable living companies. Its portfolio companies include Dreamerz Foods, a maker of sleep-aiding beverages, Expresso Fitness, a developer of cardio fitness equipment that incorporates gaming software, and Pharmaca, a chain of pharmacies that sell prescription drugs and homeopathic remedies.

Boston-based Highland Capital Partners, meanwhile, launched a $300 million consumer fund focused on specialty retail chains in 2007. That fund—led by Thomas Stemberg, founder of office supply store Staples—expects to make between 15 and 20 investments over the next three to four years. It has invested in several companies already, including Pharmaca, specialty retailer Rec Room Furniture and Games, and O Beverages, which sells bottled water infused with electrolytes.

Highland’s most famous deal to date is a $40 million investment it made with General Catalyst Partners earlier this year in Cash4Gold, a Pompano Beach, Fla.-based company that encourages people to mail in old jewelry, which it buys, melts down, and resells. The company, which has drawn numerous consumer complaints alleging lowball pricing, is a prodigious television advertiser. Just one spot—a Super Bowl ad featuring gold-decked rapper has-been MC Hammer—took about $3 million from the venture stash. (Both Highland and Catalyst have declined to discuss the investment.)

Sizing Up

The size of the Cash4Gold capital infusion and the scale of its marketing campaign stands in stark contrast to most investment rounds for consumer-facing businesses. Generally, deals skew small, rarely breaking the $5 million mark.

Small regional funds, which tend to be active in consumer-facing investments, are particularly frugal. For example, the $20 million Pennsylvania-focused fund Ben Franklin Technology Partners has put as little as $5,000 in a startup and rarely exceeds $200,000 per round.

SOMS co-investor Rand Capital invested as little as $68,000 in one consumer deal, sportswear designer Adam, and topped out at $1.3 million in its largest product investment, Niagara Dispensing Technologies, developer of a rapid beer dispensing system it claims can pour a perfect pint of Guinness Stout in under 5 seconds.

Entrepreneurs, many of whose unusual business plans would terrify a local bank lender, are grateful for what they can get.

That was the case for Stephen Pheiffer, a marine biologist in the Poconos Mountains of Pennsylvania who develops a line of products incorporating ecklonia kelp, a seaweed plant native to South Africa. His company, Cambrian Bio-Technologies, recently raised $187,000 from Ben Franklin to market its kelp-based agricultural, hair and skin care products. Pheiffer is contemplating edibles next. “Any fruit juice with a kelp additive would be a fantastic way to go,” he says. “Can you imagine, say a mango kelp juice mix?”

Developers of other offbeat product lines have raised similar micro-sized rounds in the past few months, including Oberon FMR, which sells high-protein fishmeal, ZETA Communities, a builder of homes that generate their own energy, and Ontech Operations, a maker disposable self-heating food packages.

But Will They Buy?

What we liked about [SOMS Technologies] was it’s a cleantech deal. It doesn’t involve massive infrastructure, like building a wind farm, but the technology does allow you to use less oil.”

Reid Hutchins

Consumer products startups can draw encouragement from the wide body of evidence indicating Americans may be persuaded to buy virtually anything—whether it’s a singing-fish wall hanging or bacon-flavored mayonnaise. The downside is that historical willingness to buy has resulted in more Americans having tapped out available credit. The economic slowdown has taken a further toll, with retail sales dipping sharply in the first quarter.

The question of what people will and will not buy in times of economic stress is a favored debate topic among consumer-focused investors. The consensus is that certain discretionary purchases will actually increase. The challenge is identifying them. Cue Ball’s Tjan is bullish on the concept of affordable luxuries. He thinks high-quality quick dining could do well, as cash-strapped consumers splurge on a gourmet sandwich, but forgo a sit-down restaurant lunch.

Still, one has to wonder about the timing of some of these investments. For example, Chicago-based Ascent Equity Capital last month put $1.5 million into Phoebe’s Cupcakes to help it expand to 15 to 20 locations nationwide. Gourmet cupcakes in a recession?

It sounds counter-intuitive, but former Reebok CEO Paul Fireman believes consumers will pay a premium for basic products with superior craftsmanship. His consumer-focused PE fund Fireman Capital Partners joined with Webster Capital in late March to invest $30 million in Hudson Jeans, a Los Angeles-based maker of denims that are popular among Hollywood celebrities. Fireman is betting big on niche appeal. At $175 a pair, Hudson’s pants retail for more than five times what the average consumer will pay for jeans, according to a fall survey by market research firm Cotton Inc.

Conversely, J. Hilburn, an online retailer of custom tailored shirts, has tailored its pitch to men who love nice clothes but can’t afford them. Its website notes: “At J. Hilburn, we’d like to welcome you into the world of high quality, luxuriously tailored apparel at boldly lower prices.” The pitch resonated with Battery Ventures, which has historically focused primarily on software and communications deals. It invested an undisclosed amount in a Series A for the Dallas-based clothier in April.

Others are focusing on the grocery cart. Prolog Ventures, a St. Louis-based fund that invests in wellness-oriented consumer products and life sciences companies, has backed three food startups in the past year: Lightfull Foods, maker of filling, low calorie beverages, Corazonas Foods, a seller of chips that purport to reduce cholesterol levels, and Attune Foods, a maker of snack bars that are said to aid digestion. While the items cost more than most other snacks and drinks, the firm is betting consumers will pay a premium for healthier products.

No Sale

However, such wagers often fail, and it’s common for retail and consumer products startups to have a short shelf life.

John Maynard Keynes once famously warned stock investors that “the market can stay irrational longer than you can stay solvent.” The same could be said of ever-shifting consumer tastes. Remember Heelys? Its signature wheeled sneakers were the must-have children’s fashion item of 2007. Two years after the private equity-backed company’s IPO, its shares are down 95% from their peak, and profits have turned to losses.

While it’s been a brutal year overall for consumer retail, companies that bet on the wrong trend—from monster SUVs to high-end home fixtures—have performed the worst. VC-backed companies are among the casualties, due in some cases to overconfidence in consumers’ willingness to pay more for premium goods. One of the most recent flops was Elephant Pharm, which bet that consumers would ditch big-box drugstores for a more pleasant, if pricier, shopping experience.

The drug and wellness products retailer, which had several locations in the San Francisco Bay Area, filed for Chapter 7 bankruptcy in February, a year-and-a-half after closing a $26 million round backed by Bay Area Equity Fund, CVS and Tudor Investment. The company, which targeted Baby Boomer customers with a combination of beauty products, yoga classes and prescription refills, posted a note on its website saying it was “hurt by the terrible turn the economy has taken and the tightening of the credit market.”

Even though the cost of starting a consumer electronics company has gone down over the last five years, there are still a lot of upfront costs, like tooling to create plastic housing for products or building prototypes.”

James Park

Another consumer-facing company that fizzled this year was Blue Tulip, a retail store chain that sold personalized gifts. The company filed for Chapter 11 bankruptcy in January, following a weak holiday shopping season. It had raised $32 million in the prior three years from backers including Highland Capital and Kingdon Capital.

Highland was also the largest investor in another recent flop: IMO, a startup that aimed to be a one-stop-shop for cell phone and wireless products from multiple carriers. The Waltham, Mass.-based company raised $11 million between 2004 and 2007, and is no longer in business. No announcement was made of the company’s closing, though its name no longer appears on Highland’s website and the phone number of its former headquarters is no longer in service.

Exit Roulette

With the IPO window virtually shut and a slow M&A market, retail and consumer products investors have scored few hits to counterbalance the misses. No companies have gone public in the past year, and acquisitions of venture-backed companies have been for small or unrevealed prices. The only one of note in recent weeks was Urban Decay, an edgy cosmetics company started by Cisco co-founder Sandy Lerner and marketed with the tagline “Does pink make you puke?” Castanea Partners announced in late March that it is acquiring Urban Decay from The Falic Group for an undisclosed sum.

Just a couple of years ago, consumer products companies were riding high. Highland scored one of the top-performing IPOs of 2007 with Lululemon Athletica, a provider of yoga classes and clothing. That same year, Sling Media, maker of the Slingbox device for shifting television programs to computers and handhelds, sold to EchoStar Communications for $380 million, generating solid gains for early backers DCM and Mobius Venture Capital. Another ‘07 smash was Vitaminwater maker Energy Brands, which was snapped up by Coca Cola for $4.1 billion.

Given that it can take a decade or more to build a consumer-focused company to maturity, the current poor exit environment shouldn’t scare new investors, says Cue Ball’s Tjan. He points to Chipotle Mexican Grill, a private-equity backed burrito chain founded in 1992, which was one of the most successful stock offerings of the last three years. Even Starbucks, founded in 1971, didn’t go public till 20 years later.

Early stage entrepreneurs, meanwhile, are more concerned about finding buyers for their products than for their companies.

Back at Fitbit, Park says economic conditions haven’t played a big role in marketing strategy, though constrained consumer budgets are a concern.

It’s unclear whether Fitbit’s eponymous device will prove popular with the early adopter crowd. It hits stores in the spring in the midst of what’s expected to be a difficult year for electronics retailers. The Consumer Electronics Association forecasts that sales of electronic devices will actually contract in 2009, after growing at an average annual rate of 9% the prior four years.

On the other hand, medical researchers say there’s evidence consumers will be looking for inexpensive ways to get back in shape. During economic downturns, they say, the typical American consumer, much like the average startup entrepreneur, exercises less and eats more junk food.